Stochastic Processes with Applications to Finance 2nd Kijima Solution Manual

Stochastic Processes with Applications to Finance

2nd Kijima Solution Manual

To download the complete and accurate content document, go to:

https://testbankbell.com/download/stochastic-processes-with-applications-to-finance-
2nd-kijima-solution-manual/

Visit TestBankBell.com to get complete for all chapters

Exercise 7.1 From (7.2) we have the price of call option as follows:
Cu = {uS − K}+ = 1,
Cd = {dS − K}+ = 0,
Cu − Cd uCd − dCy
∴C = + = 0.6612.
u−d (u − d)R
Similarly, we have the price of put option:
Pu = {K − uS}+ = 0,
Pd = {K − dS}+ = 0.8333,
Pu − Pd uPd − dPu
P = + = 0.2066.
u−d (u − d)R
We can obtain each side of (5.16) as follows:
K
LHS = C + Kv(0, 1) = C + = 5.2066,
R
RHS = P + S(0) = 5.2066.
Thus, the put-call parity holds.

Exercise 7.2 Substituting (7.2) into (7.6), we get

(up − dp − R + d)Cu + (uq − dq + R − u)Cd
λC = √ .
(u − d) pq(Cu − Cd )
Because 1 − p = q,
(up − dp − R)Cu + (uq − dq + R)Cd
λC = √
(u − d) pq(Cu − Cd )
(up + dq − R)(Cu − Cd )
= √
(u − d) pq(Cu − Cd )
up + dq − R
= √
(u − d) pq
= λS .

Exercise 7.3 Let p ≡ P {S(1) = uS} = 1 − p{S(1) = dS}. Then, we get the following results by some
algebra.



6 5 11 25
E[S(1)] = 5 × ×p+ 5× × (1 − p) = p+
5 6 6 6



6 11 25 5 11 25
V [S(1)] = 5 × − p + ×p+ 5× − p+ × (1 − p)
5 6 6 6 6 6

2
11
= p(1 − p)
6
   
6 5
E[C(1)] = 5 × − K ×p+ 5× −K × (1 − p) = p
5 + 6 +
  2   2
6 5
V [C(1)] = 5× −K −p ×p+ 5× −K − p × (1 − p)
5 + 6 +

= p(1 − p)
Therefore,
  
 
10 p(1 − p) 11 25 11
C= × p − 11  × p+ −5×
11 6 p(1 − p) 6 6 10
80
= = 0.6612
121

1
which is the same as obtained in Exercise 7.1.

Exercise 7.4 Constructing the node model of this security movements yields the following results:
t=0 t=1 t=2 t=3
5.000000 6.000000 7.200000 8.640000
4.166667 5.000000 6.000000 .
3.472223 4.166667
2.893519
Calculating C(t, i) at each node by using (7.3) leads to
t=0 t=1 t=2 t=3
1.395645 1.919005 2.654545 3.640000
0.437129 0.661157 1.000000 .
0.000000 0.000000
0.000000
Further we can calculate the hedging portfolio at each node as follows:
Stock
t=0 t=1 t=2
0.808296 0.906086
0.523810
0.432757
0.545455
0.000000
Money Market Account
−2.66434 −2.66434 −4.54545
−1.36603 −2.06612
0.000000
where we use
Cu − Cd uCd − dCu
w= and B= . (A.7.1)
(u − d)S (u − d)R

Exercise 7.5 The price of option at each node when T = 2 is given by

C(2, 3) = max u(uS 1+α )α (uS 1+α ) − K, 0 = 5.2809,
C(2, 2) = max d(uS 1+α )−α (uS 1+α ) − K, 0 = 0,
C(2, 1) = max u(dS 1−α )α (dS 1−α ) − K, 0 = 0,
C(2, 0) = max d(uS 1−α )−α (dS 1−α ) − K, 0 = 0,
P (2, 3) = max K − u(uS 1+α )α (uS 1+α ), 0 = 0,
P (2, 2) = max K − d(uS 1+α )−α (uS 1+α ), 0 = 0.1687,
P (2, 1) = max K − u(dS 1−α )α (dS 1−α ), 0 = 0.1687,
P (2, 0) = max K − d(uS 1−α )−α (dS 1−α ), 0 = 2.3955.
When t = 1, we have
u(1, 1) = 1.4587, d(1, 1) = 0.6855, u(1, 0) = 1.3619, d(1, 0) = 0.7342
p(1, 1) = 0.5360, p(1, 0) = 0.5826.
Thus, the option price at each node when t = 1 is given by
1
C(1, 1) = [p(1, 1)C(2, 3) + (1 − p(1, 1))C(2, 2)] = 2.5734,
r
1
C(1, 0) = [p(1, 0)C(2, 1) + (1 − p(1, 0))C(2, 0)] = 0,
r
1
P (1, 1) = [p(1, 1)P (2, 3) + (1 − p(1, 1))P (2, 2)] = 0.0711,
r
1
P (1, 0) = [p(1, 0)P (2, 1) + (1 − p(1, 0))P (2, 0)] = 0.9982.
r

2
When t = 0, we have

u(0, 0) = 1.4095, d(0, 0) = 0.7094, p(0, 0) = 0.5578.

So,we have
1
C(0, 0) = [p(0, 0)C(1, 1) + (1 − p(0, 0))C(0, 0)] = 1.3050,
r
1
P (0, 0) = [p(0, 0)P (1, 1) + (1 − p(0, 0))P (0, 0)] = 0.4373.
r
Further, we can obtain

C(0, 0) − P (0, 0) = 1.3050 − 0.4373 = 0.8677,

2
1
S− K = 0.8677,
r

which shows the put-call parity holds in this case.

Exercise 7.6 We can calculate the stock price at each node as

2 .
S(2, 3) = (1 − δ)2+α u2+α S (1+α) = 10.281 × 0.992.1 = 10.066,
2 .
S(2, 2) = (1 − δ)2−α u1−α dS 1−α = 4.831 × 0.991.9 = 4.740,
2 .
S(2, 1) = (1 − δ)2+α ud1+α S 1−α = 4.831 × 0.992.1 = 4.730,
2 .
S(2, 0) = (1 − δ)2−α d2−α S (1−α) = 2.604 × 0.991.9 = 2.555.

Therefore, the option prices at T = 2 are given by

C(2, 3) = max{10.066 − 5, 0} = 5.066,

C(2, 2) = max{4.740 − 5, 0} = 0,
C(2, 1) = max{4.730 − 5, 0} = 0,
C(2, 0) = max{2.555 − 5, 0} = 0,
P (2, 3) = max{5 − 10.066, 0} = 0,
P (2, 2) = max{5 − 4.740, 0} = 0.260,
P (2, 1) = max{5 − 4.730, 0} = 0.270,
P (2, 0) = max{5 − 2.555, 0} = 2.445.

Next, we calculate the up-factor and down-factor, and then the risk-neutral probability at t = 1:
.
u(1, 1) = u{(1 − δ)uS 1+α }α = 1.457,
.
d(1, 1) = d{(1 − δ)uS 1+α }−α = 0.686,
.
u(1, 0) = u{(1 − δ)dS 1−α }α = 1.361,
.
d(1, 0) = d{(1 − δ)dS 1−α }−α = 0.735,
R − d(1, 1) 1.1 − 0.686
p∗ (1, 1) = = = 0.537,
u(1, 1) − d(1, 1) 1.457 − 0.686
R − d(1, 0) 1.1 − 0.735
p∗ (1, 0) = = = 0.583.
u(1, 0) − d(1, 0) 1.361 − 0.735

Hence, we can get

1 − p∗ (1, 1) = 0.463,
1 − p∗ (1, 0) = 0.417,

3
and
1 ∗
C(1, 1) = [p (1, 1)C(2, 3) + (1 − p∗ (1, 1))C(2, 2)],
R
1
= [0.537 × 5.066] = 2.471,
1.1
1 ∗
C(1, 0) = [p (1, 0)C(2, 1) + (1 − p∗ (1, 0))C(2, 0)] = 0,
R
1 ∗
P (1, 1) = [p (1, 1)P (2, 3) + (1 − p∗ (1, 1))P (2, 2)]
R
1
= 0.463 × 0.260 = 0.110,
1.1
1 ∗
P (1, 0) = [p (1, 0)P (2, 1) + (1 − p∗ (1, 0))P (2, 0)]
R
1
= [0.583 × 0.270 + 0.417 × 2.445] = 1.070.
1.1
In a similar way, we get the results at t = 0 as

u(0, 0) = uS α = 1.410, d(0, 0) = dS −α = 0.709,

R − d(0, 0)
p∗ (0, 0) = = 0.558,
u(0, 0) − d(0, 0)
1
C(0, 0) = [p∗ (0, 0)C(1, 1) + (1 − p∗ (0, 0))C(1, 0)] = 1.253,
R
1
P (0, 0) = [p∗ (0, 0)P (1, 1) + (1 − p∗ (0, 0))P (1, 0)] = 0.485.
R
Then,

C + K · v(t, T ) = 5.386,
P + S = 5.485,

which shows that put-call parity does not hold when stock pays dividends.

Exercise 7.7 When d = u−1 , S(t) = Su(t+Wt )/2 d(t−Wt )/2 = SuWt . So, letting Mn∗ = max Wk , we have
0≤k≤n

C = R−T E ∗ [{M (T ) − K}+ ]


T
= R−T P {MT∗ = j|W0 = 0} max{0, Suj − K}
j=0


T
= R−T (vj (n) + vj+1 (n)) max{0, Suj − K} (∵ Exercise 6.5)
j=0


T
= R−T (n C(n+j)/2 2−n + n C(n+j+1)/2 2−n ) max{0, Suj − K}.
j=0

Exercise 7.8 Denote the option premium by C(0). Then we know that

1 
T
C(0) = {M (T ) − K}+ P ∗ {MT∗ = j | W0 = 0}.
RT j=0

4
To have C(0), we only need to calculate P  {M (n) = j | W0 = 0} for p-random walk. In this end, we use the
change of measure as follows:

P  {M (T ) = j, WT = i|W0 = 0} =E[1{M(T )=j,WT =i} YT |W0 = 0]

=E[1{M(T )=j,WT =i} m−T (θ)eθWT |W0 = 0]
=m−T (θ)E[1{M(T )=j,WT =i} eθWT |W0 = 0]
=m−T (θ)eθi P {M (T ) = j, WT = i|W0 = 0}
p
=2T (pq)T /2 ( )i/2 (vi−2j (T ) − vi−2−2j (T )) (∵ Exercise 6.5)
q

j
p
=2T p(T +j−2j)/2 q (T −i+2j)/2 vi−2j
q
− 2T p1+j q i−1−j p(T +j−2−2j)/2 q (T −i+2+2j)/2 vi−2−2j

j
p
= ui−2j − p1+j q i−1−j ui−2−2j .
q
Let

j
f (j, p, q) ≡ P  {M (T ) = j, WT = i|W0 = 0} = P  {M (n) = j|W0 = 0}.
i=−T

Then, we have


1 
T
R−d u−R
C(0) = {Su j
− K} + f j, , .
RT j=0 u−d u−d

Exercise7.9
R−d u−R
p∗ = = 0.7272, q∗ = = 0.2727
u−d u−d
When t = T = 3,

C(3, 3) = max{u3 S − K, 0} = 3.64, C(3, 2) = max{uS − K, 0} = 1,

−1
C(3, 1) = max{u S − K, 0} = 0, C(3, 0) = max{u−3 S − K, 0} = 0.

When t = 2, since

A(2, 2) = R−1 [p∗ C(3, 3) + q ∗ C(3, 2)] = 2.65428,

A(2, 1) = R−1 [p∗ C(3, 2) + q ∗ C(3, 1)] = 0.66109,
A(2, 0) = R−1 [p∗ C(3, 1) + q ∗ C(3, 0)] = 0,

and

h(S(2, 2)) = max{u2 S − K, 0} = 2.2,

h(S(2, 1)) = max{S − K, 0} = 0,
h(S(2, 0)) = max{u−2 S − K, 0} = 0,

we have

C(2, 2) = 2.65428, C(2, 1) = 0.66109, C(2, 0) = 0.

When t = 1,

A(1, 1) = R−1 [p∗ C(2, 2) + q ∗ C(2, 1)] = 1.91861,

A(1, 0) = R−1 [p∗ C(2, 1) + q ∗ C(2, 0)] = 0.43704,

5
 h(S(1, 1)) = max{uS − K, 0} = 1,
h(S(1, 0)) = max{u−1 S − K, 0} = 0

and

C(1, 1) = 1.91861, C(1, 0) = 0.43704

Finally, when t = 0, we obtain

C(0, 0) = R−1 [p∗ C(1, 1) + q ∗ C(1, 0)] = 1.37672

All results show that it is optimal not to exercise until maturity.

Exercise 7.10 The followings are the results of calculation:

h(S(2, 3)) = {(1 − δ)2.1 u2.1 S 1.21 − K}+ = 3.240

h(S(2, 2)) = {(1 − δ)1.9 u0.9 dS 0.99 − K}+ = 0
h(S(2, 1)) = {(1 − δ)2.1 ud1.1 S 0.99 − K}+ = 0
h(S(2, 0)) = {(1 − δ)1.9 d1.9 S 0.81 − K}+ = 0
h(S(1, 1)) = {(1 − δ)uS 1.1 − K}+ = 1.343
h(S(1, 0)) = {(1 − δ)dS 0.9 − K}+ = 0

A(1, 1) = R−1 [p∗ (1, 1)h(S(2, 3)) + q ∗ (1, 1)h(S(2, 2))] = 1.598
C(1, 1) = max{h(S(1, 1), A(1, 1)} = 1.598

A(1, 0) = R−1 [p∗ (1, 0)h(S(2, 1)) + q ∗ (1, 0)h(S(2, 0))] = 0

C(1, 0) = max{h(S(1, 0)), A(1, 0)} = 0

C = A(0, 0) = R−1 [p∗ (0, 0)C(1, 1) + q ∗ (0, 0)C(1, 0)]

= 0.51C(1, 1)
= 0.810

Therefore, it is optimal not to exercise until maturity.

Exercise 7.11 Rearranging (7.18) yields

Cu − Cd
= ωS,
u−d
Cu − Cm
= ωS,
u−m
Cm − Cd
= ωS,
m−d
which implies (7.19) holds. In this case, by eliminating Cm , we obtain the system which determines the
option price:
Cu − Cd
= ωS,
u−d
uCd − dCu
B= .
(u − d)R

This system is (7.1) itself, and so the option price is also the same as (7.2).

6
Stochastic Processes with Applications to Finance 2nd Kijima Solution Manual
Exercise 7.12 The condition that λ becomes a risk neutral probability is 0 < λ < 1. By equation (7.23),
d(uC − Cu )
λ= . (A.7.2)
uCd − dCu
And so, we obtain
d(uC − Cu )
0< <1 (A.7.3)
uCd − dCu
and by rearranging the above inequality, we get

uC < Cu (A.7.4)
dC > Cd . (A.7.5)

Exercise 7.15 In the three-period economy, there are four types of discounted bonds. We denote each
price as
Maturity t=0 t=1 t=2 t=3
0 v(0, 0)
1 v(0, 1) v(1, 1)
vd (1, 2)
2 v(0, 2) v(2, 2)
vu (1, 2)
vdd (2, 3)
vd (1, 3) vdu (2, 3)
3 v(0, 3) v(3, 3)
vu (1, 3) vud (2, 3)
vuu (2, 3)

Let p∗∗
d the risk-neutral probability that vdu (2, 3) realizes conditional on vd (1, 3). Then, we have
−1
vd (1, 3) = R2d [(1 − p∗∗ ∗∗
d )vdd (2, 3) + pd vdu (2, 3)],

1
where R2d ≡ vd (1,2) . Therefore, we can obtain
vd (1,3)
vdd (2, 3) − vd (1,2)
p∗∗ =
d
vdd (2, 3) − vdu (2, 3)
Similarly, if we let p∗∗
u the risk-neutral probability that vuu (2, 3) realizes conditional on vu (1, 3), then
−1
vd (1, 3) = R2u [(1 − p∗∗ ∗∗
u )vud (2, 3) + pu vuu (2, 3)]

1
where R2u ≡ vu (1,2) , and
vu (1,3)
vud (2, 3) − vu (1,2)
p∗∗
u =
vud (2, 3) − vuu (2, 3)
For the risk-neutral probalibity that vu (1, 3) realizes conditional on v(0, 3), we can easily see that

v1 (0, 3) = R1−1 [(1 − p∗∗ )vd (1, 3) + p∗∗ vu (1, 3)],

1
R1 ≡ ,
vu (0, 1)
vu (0,3)
vd (1, 3) − vu (0,1)
p∗∗ = .
vd (1, 3) − vu (1, 3)
For the bond of maturity 2, we have in a similar manner that
vu (0,2)
vd (1, 2) − vu (0,1)
p∗ = ,
vd (1, 2) − vu (1, 2)
where p∗ is the probability that vu (0, 2) realizes. But apparently p∗ = p∗∗ .

Visit TestBankBell.com to get complete for all chapters